Europe’s Improving Economy Still Faces Some Hurdles Amid Global Competition

BERLIN -- As the world's business elite gathers in Switzerland this week for the annual meeting of the World Economic Forum, optimism about Europe's laggard economy hasn't been so high since before the tech bubble burst. But don't count on Europe to float the global economy yet.

Despite a lot of good news on the corporate front, cheap global competition has kept wages and job creation flat in most of the 12-nation euro currency zone. That is a problem, because in the past it was the shopping spree following hiring and wage rises that produced full-blooded economic recoveries.

"This economic cycle is different from others," says Ken Wattret, chief euro-zone economist at BNP Paribas in London. "It's been great news for the corporate sector but not for the household sector."

The U.S. managed to get around that problem, producing surging growth in its post-2001 recovery even as wage levels and initially employment stayed flat. But that was because U.S. consumers, encouraged by rising property and stock prices, racked up credit-card bills and borrowed against their home equity to buy more cars and big-screen television sets. Continental Europeans, however, won't or can't do that.

The result: Many economists believe that euro-zone growth rates will top out at about 2%, widely considered the floor for growth in the U.S. -- let alone the tiger economies of the emerging East.

There has been a lot to celebrate lately in the core euro-zone economies. Buoyant corporate profits, fueled by exports to the U.S., Asia and oil-producing countries are pushing business-sentiment sky high. Germany's Ifo business survey, for example, shows the highest level of confidence among exporters since the survey began in 1991. Companies are finally investing their higher profits at home, especially by buying new equipment. The stock market has risen 28% in the past year, compared with 3% for the Dow.

The bad news is that on its own, an export-led recovery probably can only go so far. Domestic consumption makes up 57% of gross domestic product in the euro zone. That makes it vital for sustained 3%-plus growth rates of the kind that Germany, France and Italy used to enjoy in the 1980s. So far though, consumers aren't running out to shop, because they aren't getting any more money in their pay packets.

Able to threaten their work forces with the possibility of opening plants in Eastern Europe or China, companies are dictating wage settlements in a way they never could during past economic cycles, according to Michael Dicks, chief European economist at Lehman Brothers.

That is no different from in the U.S., but unlike Americans and Britons, Continental Europeans tend to be averse to taking on debt and are more inclined to save. Meanwhile, conservative banking rules in many core European economies don't allow Europeans to go shopping with money borrowed against the value of their homes.

Economists predict euro-zone GDP will grow by about 2% to 2.2% this year, up from an expected 1.5% in 2005. But many believe the growth rate will decline to below 2% again the year after, because of the risk that U.S. and Asian demand for European goods will slow down, while domestic consumption fails to compensate.

Some analysts believe the labor market will indeed pick up, albeit slowly. Companies enjoying rising profits are more likely, at some point, to grant their employees higher wage rises, says Julian Callow, chief European economist at Barclays Capital in London. That means the classic sequence of a European recovery should still hold, with exports fueling investment and consumption following. It's just that this time, "the responses are slower," he says.

Much slower. The euro-zone economy has been expanding modestly since 2003, yet companies' hiring intentions are still barely positive, according to surveys such as the Purchasing Managers' Index. Normally by this stage in the cycle, such indicators show clearly positive scores.

A lot depends on Germany, the world's third-biggest national economy, which makes up 30% of GDP in the euro zone. Official figures show German unemployment declining slowly, from more than 12% to nearer 11%, during the past year. But much of the reduction relates to very low-paid, state-sponsored employment schemes that do little to boost household incomes. Consumer spending in Germany has fallen in each of the past three quarters for which data are available, the most sustained decline on record. On Wednesday, the German government is expected to raise its growth forecast for this year -- to about 1.4% from 1.2%.

Some smaller European economies such as Spain and Ireland are still growing well, but Germany probably has the best outlook of the biggest euro-zone countries. German companies are seeing the strongest gains in profits, because of several years of cost-cutting and efforts to force workers into more flexible working practices. Corporate restructuring in France and Italy hasn't gone as far.

Even the United Kingdom, which has thrived outside the euro zone on a more U.S.-style, consumer-driven economy, is seeing its growth rates fall now. Britain's GDP could expand 2% this year, according to Oxford Economic Forecasting, possibly giving it lower growth than the euro zone for the first time since 1995. Given that the U.K. is one of the euro zone's most important export markets, that is one more headwind to hold back a strong European recovery.